Emergency credit market support from the Federal Reserve has sidestepped Congress and could expose the U.S. central bank to political pressure that hurts its independence, a top Fed policy-maker said on Monday.

Using the Fed's balance sheet is at times the path of least resistance, because it allows government lending to circumvent the congressional approval process, Richmond Federal Reserve Bank President Jeffrey Lacker said.

This risks entangling the Fed in attempts to influence credit allocation, thereby exposing monetary policy to political pressure, he told the National Association for Business Economics during a luncheon speech.

The Fed has cut interest rates to almost zero and more than doubled the size of its balance sheet to around $2 trillion through programs aimed at supporting private lending in a bid to prevent the more-than-year-long recession from getting much worse.

In separate remarks, Boston Federal Reserve Bank President Eric Rosengren said banks must bite the bullet and shed bad loans for the sake of a faster return to business as normal.

It would be desirable to move quickly to remove problem assets from bank balance sheets, so banks can once again focus on future prospects rather than past mistakes, Rosengren told the Institute of International Bankers.

The U.S. Treasury has proposed a public-private partnership of up to $1 trillion to remove so-called toxic assets from bank balance sheets, with public money being used to leverage private and public capital. But details of how the venture would work remain sketchy.

Incenting banks to remove these problem assets is likely to require more supervisory pressure to appropriately reserve against or write down those assets, and to take actions to quickly dispose of those assets, Rosengren said.

Lacker is a voting member of the Fed's policy-setting committee this year. He dissented at its meeting in January to protest against targeted credit-easing programs that have pumped hundreds of billions of dollars into financial markets, which have been locked up in panic over bank losses.

Lacker objected to the intrusion of the Fed into private sector lending decisions and would have preferred the central bank ease credit conditions via the purchase of U.S. Treasury securities.

At some point in the future, the Fed will need to withdraw monetary stimulus to prevent a resurgence of inflation when the economy begins to recover, he said.

That time could arrive before credit markets are deemed to be fully enough 'healed'... If monetary policy and credit programs remain tied together, as they currently are, we risk having to terminate a credit program abruptly, or else compromise on our inflation objective, Lacker said.

LET THE TREASURY DO IT

To protect the independence of the central bank, Lacker said the Fed's lending role could just as well be performed by the U.S. Treasury and financed by the issue of Treasury securities.

There would be no change in the assets and liabilities held by the public, as the additional amount of debt the Treasury issued would exactly match the additional need for assets by the Fed, if the monetary base were to remain unchanged.

Unlike the Fed, however, the Treasury can only lend under explicit authorization from Congress.

In the latest government bailout of the financial sector, the Treasury and the Federal Reserve on Monday agreed to give insurer American International Group Inc access to another $30 billion, on top of prior commitments for $150 billion in government funds.

Lacker declined to comment on the controversial topic of U.S. nationalization of big financial firms, but said government intervention deters investors, who fear future official action will dilute private capital.

It is going to be difficult to attract private equity investment into any banking firm, as long as market participants see a material probability of future government capital injections, he told reporters after the speech.

Asked about the economic outlook, Lacker said growth would rebound when the sense of panic currently encouraging households to slash spending fades.

He also played down the danger that the United States would suffer deflation similar to that of Japan, where prolonged price declines contributed to a decade of economic stagnation.

In November, I said the risk of deflation was small. If anything, I think the risk of deflation has diminished in the last month or two... We're seeing firmer core (inflation) numbers and the energy prices seem to have stabilized, he said.

(Additional reporting by Karey Wutkowski, John Poirier and Glenn Somerville in Washington and Kristina Cooke in New York; editing by Dan Grebler)

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